Management of the 10 most frequent investment risks

This article conducts a comprehensive survey of the investment risks that, as an investment adviser, I manage on an ongoing basis for my clients in the Greater Toronto Area.

Management of the 10 most frequent investment risks:

Time horizon: The amount of time you can spend to have your money tied up in an investment. Investment mismatch is when money intended for the short term is invested in a long-term strategy and vice versa. The riskiest type of mismatch is one where money is saved over the very long term, 20 years or more, and the portfolio is invested in short-term investment strategies. This approach is a two-for-one deal, as it will also eventually expose you to another investment risk, inflation.

Inflation: when things get more expensive over time. Inflation can be the biggest silent destroyer of wealth in the long run. In Canada, our average annual inflation rate has been 3.2% since 1914. This means that over a 22-year period, Canadian money can lose 50% of its original value due to inflation. Imagine saving for 30 years only to find that your purchasing power dropped much more drastically than you expected when you were ready to retire. On the other hand, a reasonable amount of inflation leads to an increase in the value of tangible assets, such as property, stocks, and some commodities. Investing in these harder assets helps manage inflation exposure over the long term. Incorporating such assets into your investment strategy involves balancing financial planning requirements with investment risk tolerance.

Interest Rates: The amount of interest you receive for lending money. Earning interest income can be an important part of your investment strategy. But beware! Interest rates are a constantly moving target that can erode the market value of your bonds, similar to the stock market. To manage interest rate risk, bond portfolios must be properly constructed by diversifying across the various characteristics of all available bonds suitable for consideration.

Liquidity: The ability to cash out your investment at any time, easily and at a fair price. It’s hard to sell something when no one wants to buy it. Worse is when there are enough distressed sellers in a market at any given time that they can drive prices down, ever lower. To effectively manage investment risk related to liquidity, I recommend diversifying your investment portfolio holdings and never putting all your money in one asset class.

Recessions: when the economy sucks! Recessions are a natural part of the economy. They can be very hard on people, I agree, but as investors they can present us with good buying opportunities and prepare us for the eventual spring or economic recovery. The opportunities to manage this risk arise, in part, because different countries may be at different points in the business cycle at the same time, and certain industries and sectors may experience their own business cycle. In basic terms, not everything is flushed down the toilet at the same time.

Dominant trends: when things do not change for a long period of time. Beneath the general economic climate is the main dominant trend of an economy or even a specific industry. This dominant trend, despite its ups and downs, generally leans in a long-term direction. As an example, at one point, the Japanese stock market was the darling of the investment world. In 1990, its dominant trend shifted downward. Investors who bought into the peak of the Japanese market in 1990 and held on to their investments were still under water 20 years later. Even though there were periods of growth along the way, the stock market failed to reach new heights. The typical investors who made money in this market were those who went against the traditional buy and hold investment strategy.

Volatility: The degree to which the value of your shares rises and falls. There is a direct relationship between the uncertainty of an economic climate and the volatility of certain investments. However, volatility is not necessarily an investment risk in and of itself. For example, if an investment doubled your money over a 6-year period, you might conclude that it was a great investment and not so risky after all. If, on the other hand, that 6-year period was so volatile that it had, not one, but several crashes, would you still agree that it was a good investment? In this example, investment risk is about whether we will ride the roller coaster or end up cashing in our chips before time runs out. Volatility leads to emotional investing, even for hard-core investors. Good portfolio construction manages volatility, like investment risk. It strives to give investors a pleasant ride without sacrificing returns.

Bear Markets – When prices in the stock market have been hit and everything looks bleak. The bear market is actually an industry term. It’s when the stock market goes into a funk after a good long run. Bear markets can be short and shallow, or they can be long and deep. It’s hard to predict the exact start or end of a bear market, but once you’re in the bear’s den, running away from the bear (selling low) is rarely a good strategy. Getting defensive helps manage investment risk and prepare cash and investments for the eventual end of the bear market.

Bull Markets: When prices in the stock market keep going up and everyone is happy. Yes, believe it or not, bull market is also an industry term. It is the opposite of a bear market. The investment risk associated with a bull market is that it can make investors (and advisers) overconfident that easy money can be made without exposing themselves to investment risk. Knowing when the bull market is about to end is also tricky. Finding newer, younger bull markets is generally the best way to manage investment risk when a mature bull market comes to an end.

Impatience: The uneasy feeling you get when your investment doesn’t grow fast enough and you sell too soon. I can’t tell you how difficult it is to overcome this investment risk. It simply is. If all the dots have connected and nothing has changed for an investment to turn bad, then sometimes the best approach is to be patient and wait for the price to rise again.